General Theory - Hedging

Hedging Not all futures trading is about moving goods to market. Hedging, or entering into a transaction in order to reduce existing exposure to price fluctuations, is also a major component of trading volume.

Risk ReductionJust about any trader can be a hedger at some point in time; it is a function more than a job description. If a trader already holds the physical goods or the futures contracts to deliver them, or else has the offsetting short position, then she might act as a hedger on her next trade. Hedging is done to decrease risk.

When you buy a futures contract, you agree to pay a certain price for a given quantity of a good. The counterparty who sells the contract is agreeing to the same terms. However, over the months-long course of the contract, circumstances beyond the control of either party can occur that affect the spot price on the delivery date, causing it to vary wildly from the price anticipated in the contract. When that happens and neither the buyer nor seller has hedged positions, then someone is going to end up with a windfall and the other is going to be paying for it.

Hedging, then, has a stabilizing effect on commodities pricing.

Long HedgingIn a long hedge, the hedger buys a futures contract. Typically, this is done by someone who adds value to the commodity: processors, manufacturers, exporters or anyone who is going to need a known quantity of a commodity at a fairly specific point in the future. These types of end user are commercial hedgers.

Suppose a large snack food company knows in July that, in September two months hence, it will need 50,000 bushels of corn to keep its tortilla chip factory running. The CBOT reports the following prices for 5,000-bushel contracts, denominated in cents/bushel:

Spot: 235

SEP: 246

DEC: 260

Domestic demand for corn is growing at a fairly constant rate; supply could keep up, but new markets, unfavorable weather and any number of other factors, could determine how much of the crop would be available to the tortilla chip market and at what price. Our snack food company doesn't have the facilities to store the corn available on the spot market at $2.35/bushel, but decides that the $2.46 price for September corn still provides a reasonable profit margin. The $2.60 December price, though, indicates that the spot price of corn will keep climbing at an accelerating rate, and $2.60 is far more than the processor is willing to pay for a bushel of corn.

So the company buys ten 5,000-bushel SEP contracts at 246 cents/bushel. In September, it turns out that the new spot price is 248 cents/bushel. Because of all the procedural complications of taking delivery of a futures contract, the company will sell the contract just before it expires. By this point, the futures price will equal the spot price and the company will be able to engage in what's called a reversing trade and sell the contract at 248 cents/bushel.

The company will then buy the 50,000 bushels of corn on the spot market.

If you do the math, you'll see that the hedger has apparently bought $124,000 worth of corn in September for an investment of $123,000 in July. Still, that's not a real $1,000 profit if you consider the company could have bought the same amount of grain for the lower price on the spot market at the time it bought the future. It merely eliminated the cost of storage while adding on transaction costs.

LOOK OUT!

The profit and loss in a deal like this is typically negligible. The transaction is more accurately viewed as an insurance policy. A long hedge protects a trader against unanticipated price rises. That did not occur in this example. The September spot price was only a couple cents higher than the market thought it would be two months earlier. If there had been a rash of tornadoes in the Midwest or a huge order placed by a large overseas trading partner, then September spot price could have risen to 260 cents/bushel, or even higher, and the company would have been very happy it had the long hedge.

Short HedgingIn a short hedge, the hedger sells a futures contract in order to limit exposure to a price shortfall. Typically, this is done by farmers, miners or anyone who, for whatever reason, is holding the inventory (commercial hedgers).

In a short hedge, the hedger sells a futures contract. Assume you're an agent for the farming cooperative in Nebraska that grows the corn underlying the contract described above, in the section on long hedging. You would enter into the same deal as the tortilla chip maker, but your incentive would be to limit the risk if corn prices declined sharply. If a large expected order did not materialize, if a developing nation should suddenly dump lower-cost corn on the world market or if unusually favorable summer weather should cause a supply glut, you know that there are at least 50,000 bushels you can sell at a price you can live with.

LOOK OUT!Mechanically, the short hedger sells the contracts at the futures price to open the hedge, then, essentially, buys it back at the prevailing spot price to close it.